Using Philosophical and Economic analysis to consider big questions, world issues and matters of everyday life!

Saturday, 29 April 2017

What Babysitting Can Teach Us About The Economy

Let me tell you a story
about babysitting, first told by economist Paul Krugman. The story involves The
Capitol Hill Babysitting Co-Op, which consisted of many couples who baby sat
for each other using the currency of scrips, which were pieces of paper with 30
minutes' worth of babysitting time on each.

Couples earned scrips by
babysitting, and they purchased other couples' babysitting time with scrips.
Couples all started with 20 scrips (10 hours of babysitting time), but over
time there was a problem, because couples became reluctant to use their scrips,
which diminished the demand for babysitters. This made it harder for
babysitters to sell their babysitting time, which in turn incentivised couples
to hoard their scrips, thereby creating a babysitting recession.

So the story goes, Capitol
Hill decided that the solution to kick start the babysitting economy was to
issue couples with more scrips, which stimulated the demand for babysitting by
making couples keener to go out. As more babysitting jobs became available,
couples became more incentivised to go out themselves, and voila, the
babysitting economy was back in full flow.

The analogy to
macroeconomics, according to Krugman, is that in recessions it is harder to earn
money as people spend less money, so the economy can be kick-started
Keynesian-style by governments issuing more money. This is flawed for two
reasons; firstly, when governments issue more money into the economy there are
enormous concomitant deadweight costs to the price system. And secondly, the
economy isn't like the Capitol Hill Babysitting Co-Op because money is more
dynamic and so are prices.

The problem with the
babysitting recession was down to what's called sticky prices. Sticky prices is
the term for when prices don't adjust quickly enough to changes in the economy.
For example, a chain of ice cream parlours may find that an increase in the price
of ingredients makes providing ice cream slightly more expensive. But despite this, changing
all the prices on the signs and advertising boards may be not worth their
while, so their prices stick. Another example, the marginal value of waitresses may decrease by 50p an
hour, but restaurants who've invested time in their waitresses may not wish to
reduce their hourly rate or recruit new staff.

Price changes can be
costly for businesses, particularly in large organisations with tens of
thousands of prices to alter on shelves, and the management time required to
research optimal prices, to keep an eye on competitors, organise sales staff
and negotiate with consumers - sometimes it pays to remain with the status
quo.

Anyway, back to the
babysitting co-op - the problem the couples found was that prices were sticky,
but also that there was no negotiating to stimulate supply and demand such as you
find in a real economy. For example, in a babysitting recession couples could negotiate the value of their
scrips to bid up demand for babysitters, which would increase the supply of
babysitters.

The place that Krugman's
analogy falls short is in the fact that money in an economy is not like the scrips, because
the scrips were confined only to babysitting, whereas money is confined to
anything you want to spend it on. In other words, unlike the scrip, there is
nothing on a five pound note that says it must be spent on babysitting, so not
only do prices adjust more freely in a market economy by supply and demand
changes in one good or service, they do so in relation to every other good and
service too. In the babysitting cooperative, there is not much fungibility -
which means you cannot say you don't want a babysitter so you'll go out for the
night by buying a toaster instead. In an economy, however, if prices rise for apples,
you can always eat oranges, or bananas or cereal.

This is why the government
printing money is almost always bad for the economy, even if the intentions are sometimes good.
To see why with an illustration, have a look at the graph below. Suppose the product in question is bunches
of bananas, and the equilibrium point - the point at which quantity supplied and
quantity demanded are equal - is £1.20 a bunch, and 2 million bunches are sold
per week in the UK.

Now suppose the market for
bananas got thrown off equilibrium by a 20% tax. Bananas are now £1.44 a bunch,
and because the tax is passed on to the consumers, let us now say only 1.8
million bunches are sold per week. The tax has effectively reduced banana sales
by 10%, which negatively impacts buyers and sellers, and denies society lots of consumer and producer surpluses.

Printing money causes increased
inflation, which is rather like a tax because those who hold money lose
purchasing power. Inflation is to holding money as income tax is to earning an
income, therefore printing money is like increasing the tax on savings, which
has a knock on effect of altering consumer prices away from their equilibrium
point, which then robs society of some of the value created in a free market of
supply and demand.Other government interference, like price controls, taxes and regulations cause further exacerbation to this problem, because they affect the market value of goods and services, which means many firms lack sufficient information to act, which means falling sales, reduced costs, wage cuts, job losses and reduced consumer demand in a downward circular spiral.

About Me

This is the Blog of James Knight - a keen philosophical commentator on many subjects.
My primary areas of interest are: philosophy, economics, politics, mathematics, physics, biology, chemistry, theology, psychology, history, the arts and social commentary.
I also contribute articles to the Adam Smith Institute and the Institute of Economics Affairs.
Hope you enjoy this blog! Always happy to hear from old friends and new!
Email:j.knight423@btinternet.com